To cool a market meltdown, apply aid carefully

Earlier this week, and in previous actions since August, the Federal Reserve has done what any self-respecting central bank would do during a time of severe financial stress: It has offered banks extra financing to avoid a contagious panic.

The aim isn't to bail out faltering firms, but to restore "liquidity," the normal flow of transactions and credit.

Parts of the banking system still aren't functioning normally. With mortgage-related investments causing billion-dollar losses, banks' lending to one another has been disrupted. And the cost differential between a large home loan and a small one is wider than usual. Worries about a wider credit crunch in bank lending remain high.

In both the short and long term, policymakers must walk a careful line.

The short-run challenge is to let the markets learn from their mistakes, but prevent a credit contagion that could increase the risk of a recession. That's where the Fed's recent actions come in. Interest-rate cuts – including a possible move in December – and the Fed's action as a backup lender to banks helped fuel a midweek rally in stock prices.

In the longer run, lawmakers and regulators must weigh how best to oversee these increasingly complex investments.

"The key is to balance the need to let markets continue to innovate with protecting the public from the fallout during the rare times when those innovations go awry," says Eric Beinhocker of McKinsey Global Institute.

Financial innovation has brought big benefits, such as cheaper loans and better investment options, says Mr. Beinhocker, author of a book on financial complexity, in an e-mail interview. But it has also played a role in the recent turmoil in credit markets. Despite the Fed's early efforts, and this week's hopeful stock-market signals, those financial strains remain an urgent concern on Wall Street.

US banks are struggling to cover losses in complex investments that packaged together the income from various types of debt – including the riskiest home loans, known as subprime mortgages. When the housing market turned sour, those subprime loans began to go bad and hit these investments – called "collateralized debt obligations" or CDOs – with unexpectedly large losses.

Banks also face large related losses in off-the-books ventures called structured investment vehicles (SIVs). These ventures invested in bundles of long-term debt to earn a high income, and they paid for it with short-term loans. Now the sources of short-term funding have dried up for many SIVs. That leaves banks with a large liability to keep some $300 billion in SIV investments afloat.

The danger? If many banks are forced to sell the assets of these funds all at once, a fire sale could result in big losses. Right now, SIVs aren't finding buyers.

In response, banks are moving to set up a so-called "superfund," with as much as $75 billion in voluntary contributions, to buy at least the higher-quality assets. Treasury Secretary Henry Paulson backed this move in October. Banks hope the fund will be up and running before the end of the year.

In the best scenario, the fund would nurture wider buying and selling of SIV assets. A fundamental problem now is that, without active trading, no one really knows what the investments are worth.

Some economists worry that the manager of the new superfund will buy assets at artificially high prices – perhaps in deference to the sponsoring banks.

"If people think that this is creating fake prices ... then it's just postponing true price discovery" and a wider market for SIV assets, says Raghuram Rajan, a University of Chicago economist. Disclosure is needed not just for the SIV problem, but more broadly for the financial position of banks in general, he adds.

For now, lenders and stock investors remain on edge because of uncertainty.

Banks like Citigroup and investment houses like Merrill Lynch have seen big declines in share price, but no major institutions have gone bankrupt so far.

"Eventually, the banks that hold these SIVs will have to start selling off these assets at distressed prices, says Peter Wallison, a finance expert at the American Enterprise Institute, a conservative think tank in Washington.

But the worst policy response, he says, would be to provide too much help. That would send a signal causing more irresponsible borrowing or investing in the future. Indeed, some experts say that periodic financial crises offer a vital cleansing mechanism for the economy, preventing the buildup of future financial bubbles.

But others say that long-term policy responses are needed to make the financial system safer. This could include closer supervision of banks and hedge funds.